Accounting equation explained

Accounting equation explained


How does the accounting equation work, and what are some examples of using the accounting equation? The accounting equation states that assets
always equal liabilities plus equity. Assets are what a company owns, and they are recorded on the left hand side of the balance sheet. What a company owes is recorded on the right
hand side of the balance sheet, and can be split between liabilities (what is owed to
creditors) and equity (what is owed to shareholders). Assets equal liabilities plus equity. If assets go up, then liabilities and equity
also must go up. If assets go down, then liabilities and equity
also must go down. Let’s illustrate the accounting equation
with some examples. When the company is started, the entrepreneurs
starting the company send cash from their personal bank account to the company’s bank
account. The company records 100 thousand dollars in
assets (it is cash that the company owns), and 100 thousand dollars in equity (the money
is owed to the shareholders). If we check the accounting equation, we find
that assets of 100 thousand dollars equal liabilities which are zero plus equity of
100 thousand. What we own equals what we owe. The company then buys some inventory from
a supplier on credit. Inventory is an asset the company owns, accounts
payable (an invoice received from a supplier but not paid yet) is a liability that the
company owes. Let’s check the accounting equation. Assets of 150 thousand dollars equal liabilities
of 50 thousand dollars plus equity of 100 thousand dollars. Next step is for the company to sell that
inventory to a customer on credit. Accounts receivable are an asset the company owns (invoices sent to a customer that have not been paid yet). To complete the sales transaction, the company not only sends an invoice, but also ships the goods. Inventory therefore goes to zero. As the company sells the goods for 80 thousand
dollars, while it bought the goods for 50 thousand dollars, the company makes a profit
of 30 thousand dollars. Assuming no corporate income taxes for startup
companies (which is not the case in real life), the profit on that transaction will end up
in retained earnings, which is part of equity. Let’s once again check the accounting equation. Assets of 180 thousand dollars equal liabilities
of 50 thousand dollars plus equity of 130 thousand dollars. There can also be movements between accounts
within one category. The company decides to buy a small delivery
van to deliver the goods. Fixed assets (property, plant and equipment)
go up 25 thousand dollars, cash goes down 25 thousand dollars. Assets of 180 thousand dollars equal liabilities
of 50 thousand dollars plus equity of 130 thousand dollars. The accounting equation is the foundation
for double entry bookkeeping. You could even see the accounting equation
as the most important concept in accounting – period! Assets equal liabilities plus equity. Want to learn more about business, finance
and accounting? Then subscribe to the Finance Storyteller
YouTube channel! Thank you.

8 thoughts on “Accounting equation explained

  • March 4, 2019 at 3:46 pm
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    dat was echt een goed voorbeeld.

    Reply
  • March 4, 2019 at 5:07 pm
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    Thank you so much! <3

    Reply
  • March 9, 2019 at 7:46 am
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    Your all videos are very informative. Keep it up.

    Reply
  • June 13, 2019 at 7:25 am
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    Why and where are you learning about the accounting equation? Let me know by commenting below!

    Reply
  • August 30, 2019 at 6:08 am
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    cheers niki lauda

    Reply
  • October 3, 2019 at 1:29 pm
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    Enjoyed this explanation of the accounting equation? Then subscribe to my channel, and watch the related video on debits and credits https://www.youtube.com/watch?v=n-lCd3TZA8M and the video on making journal entries using double entry accounting (with examples!) https://www.youtube.com/watch?v=EibibVFEkvk

    Reply
  • October 15, 2019 at 7:08 pm
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    Ahh, that makes sense now! I've understood this relationship before, but never the convention that dictates which terms are shown on each side of the equation. Thinking of equity as something that the company owes to shareholders was the missing piece for me.

    As a sole proprietor, I always think of things in terms of my equity in my company – specifically, the value of the company to me (E) is whatever it has (A) minus whatever it owes to other people (L). Correspondingly, I internalized the accounting equation as E = A – L. That's "correct" in an algebraic sense, but only makes practical sense in the special case where there's one owner who has all of the equity. I can see the utility of expressing this "properly" in the A = L + E sense, because is more generally useful for companies with more than one equity holder. If I think of my company as "owing" me my equity, it makes sense for me, too. Thank you!

    Now, on to understanding why we sometimes use the terms "debit" and "credit" in the seemingly opposite way to what they mean in normal English…

    Reply
  • December 29, 2019 at 5:50 pm
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    Now you unlooped the clumsiness in my head regarding why are they equal

    Thank you very much

    Reply

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